Earnings growth is the annual rate of growth of earnings from investments.
Contents
Overview
Generally, the greater the earnings growth, the better.
When the dividend payout ratio is the same, the dividend growth rate is equal to the earnings growth rate.
Earnings growth rate is a key value that is needed when the DCF model, or the Gordon's model is used for stock valuation.
The present value of stock is given by
where P = the present value, k = discount rate, D = current dividend and
If the growth rate is constant for
The last term corresponts to the terminal case. When the growth rate is always the same for perpetuity, the Gordon's model results:
As the Gordon's model suggests, the valuation is very sensitive to the value of g used.
Note that part of the earnings is paid out as dividends and part of it is retained to fund growth, as given by the payout ratio and the plowback ratio. Thus the growth rate is given by
Note that for S&P500, the return on equity has ranged between 10 and 15% during the 20th century, the plowback ratio has ranged from 10 to 67% (see payout ratio).
Other related measures
It is sometimes recommended that revenue growth should be checked to ensure that earnings growth is not coming from special situations like sale of assets.
When the earnings acceleration (rate of change of earnings growth) is positive, it ensures that earnings growth is likely to continue.
Historical growth rates
According to economist Robert Shiller, earnings per share on the S&P 500 grew at a 3.8% annualized rate between 1874 and 2004 (inflation-adjusted growth rate was 1.7%). Since 1980, the most bullish period in U.S. stock market history, real earnings growth according to Shiller, has been 2.6%.
The table below gives recent values of earnings growth for S&P 500.
The Federal Reserve responded to decline in earnings growth by cutting the Intended federal funds rate (from 6.00 to 1.75% in 2001) and raising them when the growth rates are high(from 3.25 to 5.50 in 1994, 2.50 to 4.25 in 2005).
P/E ratio and growth rate
The growth stocks generally command a higher P/E ratio because their future earnings are expected to be greater. In Stocks for the Long Run, Jeremy Siegel examines the P/E ratios of growth and technology stocks. He examined Nifty Fifty stocks for the duration December 1972 to Nov 2001. He found that
This suggests that the significantly high P/E ratio for the Nifty Fifty as a group in 1972 was actually justified by the returns during the next three decades. However, he found that some individual stocks within the Nifty Fifty were overvalued while others were undervalued.
Sustainability of high growth rates
High growth rates cannot be sustained indefinitely. Ben McClure suggests that period for which such rates can be sustained can be estimated using the following:
Relationship with GDP growth
It has been suggested that the earnings growth depends on the nominal GDP, since the earnings form a part of the GDP. It has been argued that the earnings growth must grow slower than GDP by approximately two percent.